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Lessons from Continental Illinois for fixing the financial system

Even as policymakers and voters debate the decisions made during the last financial crisis, economists are thinking about how to ward off the next one.

Since the federal rescue in 1984 of Continental Illinois National Bank and Trust Company, which created the notion that some banks are "too big to fail," financial firms and their investors have expected the government to step in to avert a widespread panic. These expectations distort markets, as demonstrated in research by Bryan Kelly, assistant professor of finance at Chicago Booth, and give banks incentives to take excessive risk. Former Treasury Secretary Timothy Geithner's new book has revived all the old arguments about the "moral hazard" of failing to hold banks accountable. The 2010 Dodd-Frank financial overhaul law is supposed to end taxpayer bailouts of failed banks, but many questions remain about the details of its implementation.

If the financial system appears on the brink of collapse, regulators will face intense pressure to intervene. The question, then becomes how to halt problems at one bank before they spread to others. Some economists and policymakers are focusing on stopping bank runs, when depositors rush to pull out their funds amid rumors that a bank is failing. Suggestions for avoiding a bank run were among the key proposals discussed at a day-long Chicago Booth conference, organized by the Stigler Center for the Study of Economy and the State, examining the rescue of Continental Illinois and its implications for today's "too big to fail" banks.

One way to prevent a run might be to require banks to fund themselves primarily with equity rather than short-term liabilities, such as deposits, said John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance at Chicago Booth. What might this look like in practice? Suppose customers wanted a safe account that didn't change in value. They could invest in a money-market fund backed 100 percent by US Treasuries, Cochrane suggests. If customers wanted the potential for a greater return, they could buy securities issued by the bank that, like stocks, could rise or fall in value.

(For more on these ideas from Cochrane and Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance, another panel participant, see this video and the article "What Occupy Wall Street Should Have Said" in the Summer 2013 issue of Capital Ideas. Cochrane recently gave a broader explanation of his proposal in an essay linked at his blog, "The Grumpy Economist.")

Cochrane said Continental Illinois set a pattern for bailouts that can only be broken with a new approach. "That was the beginning of the modern era of the view that all creditors shall be bailed out," he said. "Then we said we were going to intensify asset regulation to deal with the moral hazard, so it wouldn't happen again. Then it happened again. Each time, more and more creditors got guaranteed to stop them from running."

Panelist John Dugan, the US comptroller of the currency from 2005 to 2010, agreed that the issue of whether a large bank can be allowed to fail without causing a run is "the central question for policymakers."

Dugan suggested that banks should be required to have a large cushion of subordinated claims; in other words, the holders of those claims will absorb the first losses. That means that if a bank runs out of capital and has to close, the claims to guaranteed, short-term creditors will be paid out of that cushion, averting a run. This approach is sometimes called "single point of entry," or a "bail-in," because the bank uses the cushion to fund its own closure.

"Then you have to convince creditors that you really mean it," Dugan said. "You have to have enough of a cushion that it is highly unlikely that you'll run through it all. You also need a source of temporary government liquidity that can be extended on a secured basis—not a bailout—available to reassure short-term creditors that they will be protected."

Not everyone agrees that these proposals will solve the problem. Randall S. Kroszner, Norman R. Bobins Professor of Economics at Chicago Booth and former governor of the Federal Reserve System, has argued that making banks less risky will simply shift that risk to other parts of the financial system, leaving the overall system vulnerable to a crisis.

"I question whether you can ever eliminate too-big-to-fail institutions," said panelist Roberta Romano, Sterling Professor of Law and Director of the Yale Law School Center for the Study of Corporate Law. "People remember that the government didn't bail out Lehman Brothers, and that was a catastrophe."

Instead, Romano argued, regulators should reduce incentives for risk-taking, by requiring that bonuses for senior bank executives be paid in restricted stock and options that can't be exercised until two to four years after their last day working at the bank. She also said countries should be encouraged to experiment with different regulatory standards, since no one knows which ones will prove to be optimal.

Romano did agree with the other panelists that banking should be made less risky; in her case, she advocated for higher capital requirements.

Overall, the discussion showed the increasing attention to the concept of "narrow banking"—the idea that banks should hold safer assets to avoid the problem of depositors rushing for the exits. (Recently, on the website for his new book House of Debt, Amir Sufi, Chicago Board of Trade Professor of Finance at Chicago Booth, explained the history of the debate over "100% reserve banking," a form of narrow banking advocated by both Cochrane and Martin Wolf, chief economics commentator for the Financial Times.)

Thirty years after the rescue of Continental Illinois, the panelists believed "too-big-to-fail" is still a very real threat. "What we didn't hear much about in the discussion today is whether we really think we've made progress in improving the incentives for financial institutions to keep themselves out of trouble," Diamond said. "It's very important to think about using financial contracts to commit banks to stay on a safe course."